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Finding Value in Spread Product Finding Value in Spread Product

Finding Value in Spread Product - PowerPoint Presentation

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Finding Value in Spread Product - PPT Presentation

Government Investment Officers Association Conference B Hunter Hill Total Return Strategist SunTrust Robinson Humphrey 615 7485953 HunterHillsuntrustcom February 25 2016 Finding Value in Spread Product GIOA March 23 2016 ID: 530006

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Slide1

Finding Value in Spread ProductGovernment Investment Officers Association Conference

B. Hunter HillTotal Return StrategistSunTrust Robinson Humphrey(615) 748-5953Hunter.Hill@suntrust.com

February 25, 2016

Finding Value in Spread Product – GIOA – March 23, 2016Slide2

Table of ContentsSECTION

1 What Risks Am I Getting Paid For? [ 02 ]SECTION 2 Interest Rate Risk [ 10

]SECTION 3 Credit Risk [ 15 ]SECTION 4 Option Risk & OAS [ 19 ]SECTION 5 Liquidity Risk [ 26 ]SECTION 6 Your Questions [

30

]

Of Correlation & Causation

– February 25, 2016

1

This presentation is for informational purposes only and is being furnished on a confidential basis. By accepting this information, the recipient agrees that it will use the information only to evaluate its potential interest in the strategies described herein and for no other purpose and will not divulge any such information to any other party.

This presentation does not constitute a commitment to lend money, underwrite any proposed transaction, purchase securities or other assets, provide financing, arrange financing, or provide any other services. SunTrust Robinson Humphrey, Inc. and its representatives and affiliates make no representation and have given you no advice concerning the appropriate regulatory treatment, accounting treatment, or possible tax consequences of the proposed transactions described herein. Prior to entering into any proposed transaction, you should determine, without reliance upon SunTrust Robinson Humphrey, Inc. or its representatives or affiliates, the economic risks and merits, as well as the legal, tax and accounting characteristics and consequences, of the transaction and that you are able to assume these risks. These materials should not be relied upon for the maintenance of your books and records or for any tax, accounting, legal or other purposes.

All materials, including proposed terms and conditions, are indicative and for discussion purposes only. Finalized terms and conditions are subject to further discussion and negotiation and will be evidenced by a formal written agreement. Except as required by applicable law, we make no representation or warranty, express or implied, to you or to any person as to the content of the information contained herein. Opinions expressed herein are current opinions only as of the date indicated. Any historical price(s) or value(s) are also only as of the date indicated. We are under no obligation to update opinions or other information.

In connection with Treasury Regulation Section 1.6011-4, it is our mutual intent that the tax structure and tax treatment of the transactions contemplated by this presentation are not confidential and that notwithstanding anything herein to the contrary that each of us (and our employees, representatives and agents) may disclose to any and all persons, without limitation of any kind, the tax structure and tax treatment of the transactions contemplated herein. Slide3

What Risks Am I getting Paid For?Section 1

2Finding Value in Spread Product – GIOA – March 23, 2016Slide4

Who Wouldn’t Want This?6% YieldPriced at $102Matures Inside Five Years

3Finding Value in Spread Product – GIOA - March 23, 2016Low single-B high yield callable bond for a company that owns T.V. stations.

Probably not the kind of thing you’re going to bet the people’s money on.Slide5

The Components of Yield4

Finding Value in Spread Product – GIOA - March 23, 2016Risk-Free Rate of ReturnInterest Rate Risk CompensationCredit Risk CompensationOption Risk CompensationLiquidity Risk Compensation+ Error s

Total YieldSlide6

Risk-Free Rate? Depends

5Finding Value in Spread Product – GIOA - March 23, 2016To Talk About Spread Product, We Have to Talk About What They’re Spread AgainstSource: Library of CongressSlide7

Short-Term Treasuries as the Risk-Free Rate

6Short-Term T-Bills carry minimal credit, interest-rate, and liquidity risk and no option risk. Therefore, we generally consider this the “risk free rate.”Heavily influenced by the target rate for fed funds and Federal Reserve policy.Finding Value in Spread Product – GIOA - March 23, 2016Slide8

Treasuries Have Credit Risk, Too!7

Finding Value in Spread Product – GIOA - March 23, 2016Source: Bloomberg LPSlide9

Treasury Curve Carries RiskWe have to think about relative value not only in Agencies or mortgages or corporates or municipals, but also on the curve.Where was the relative value when the curve was inverted in 2006-early 2008?

Where was the relative value when curve was so flat in April 2013?Where is it now?8Finding Value in Spread Product – GIOA - March 23, 2016Slide10

Spread Product Curves

9Finding Value in Spread Product – GIOA - March 23, 2016Slide11

Interest Rate RiskSection 2

10Finding Value in Spread Product – GIOA – March 23, 2016Slide12

What is Interest Rate Risk Compensation?The amount of imbedded return or yield included for the risk that a bond’s price will decline due to an increase in interest rates. Generally speaking, the longer the bond, the higher the interest rate risk, the greater the yield.

11Finding Value in Spread Product – GIOA - March 23, 2016Slide13

Introduction to “Nominal Spreads”Nominal spread is simply the increase in yield over a benchmark as you increase risk.The 2s5s curve (dark blue) is the increase in yield you get from moving from a 2-year Treasury to a 5-year Treasury.This is the nominal measure for interest rate risk compensation, without adjusting for the increase in risk.

12Finding Value in Spread Product – GIOA - March 23, 2016Slide14

The Nominal Yield Pick Up Approach

13Yield Curve as of 8/7/15Yield Curve as of 2/28/16

Recently, the curve has been much less smooth and much flatter.Creates more opportunity for relative value trade, even though the absolute values are lower.For example, you might buy the 4-year and the 6-year instead of the 5-year, given how the 5-year is relatively less attractive.While the curve was not historically steep, back in August, it was significantly steeper. Long-end was higher in rates, and the fed funds target was still at 0%-0.25%.Finding Value in Spread Product – GIOA - March 23, 2016Slide15

Beyond Nominal: Duration-Weighted Approach14

Finding Value in Spread Product – GIOA - March 23, 2016Slide16

Credit Risk Relative ValueSection 3

15Finding Value in Spread Product – GIOA – March 23, 2016Slide17

Broad Sector Comparison

16Finding Value in Spread Product – GIOA - March 23, 2016Slide18

Single-Security Spread ChangeHere is a graph of CSCO 1.65 6/18, which has been a reasonably “mean-reverting” bond. High quality tech name (A1/AA-) with a short duration.The spreads has been more volatile of late, perhaps affording the chance to buy at a wider level?TRACE gives a general area, but don’t get wedded to it. TRACE tells us where we’ve been, but doesn’t necessarily tell us where we’re going.

17Source: TRACE ReportingFinding Value in Spread Product – GIOA - March 23, 2016Slide19

Mechanical Approach to Sector Comparison: Leverage versus Spread

18Finding Value in Spread Product – GIOA - March 23, 2016Leverage (Total Debt/EBITDA) gives us a fundamental metric by which to measure credit.Here, a pharmaceutical credit with low leverage but high spread might be an opportunity.Or it might be a pitfall. The case of TEVA.

Source: STRH Fixed Income TradingSlide20

Option Risk & OASSection 4

19Finding Value in Spread Product – GIOA – March 23, 2016Slide21

Nominal Spread Approach

20Source: STRH Fixed Income TradingFinding Value in Spread Product – GIOA - March 23, 2016Slide22

What Is a Callable Bond? A Theoretical Approach“Beware of geeks bearing formulas.” – Warren Buffett

21

In theory, a callable is being long a bullet and selling a call option to the borrower. So…Callable Bond = Bullet – Call Option

Further, three geeks by the name of Black, Scholes and Merton figured out a pricing model for call options on stocks, which we generally apply to other asset classes as well, including interest rate options:

Call Option = f(Price, Exercise Price, Expiration, Volatility, Risk-Free Rate)

For our purpose, since most callables are issued at par (that is, Price = Exercise Price), and rates are a basic feature of our bond return, we focus on expiry and volatility, or:

Callable Bond = Bullet Bond – f(Expiry, Volatility)

Finding Value in Spread Product – GIOA - March 23, 2016Slide23

Theoretical Value in CallablesCallable Bond = Straight Bond – f(Expiry, Volatility)

22Shorter Lockouts Generally Get More Yield

Higher Interest Rate Volatility Always Gets More YieldHigher Yield on Straight Bond Means Lower Price Here – And Higher Yield for CallablesFinding Value in Spread Product – GIOA - March 23, 2016Slide24

The Higher the Volatility, the More Yield Over Bullets

23Finding Value in Spread Product – GIOA - March 23, 2016Sources: Deutsche Bank; Bank of America Merrill Lynch; Bloomberg LPSlide25

OAS Problems

24Finding Value in Spread Product – GIOA - March 23, 2016Bullet on Bloomberg, using Wall Street trader conventions, shows OAS of +14.5 over interpolated Treasuries.Yields 1.375%.

Quarterly Callable picks up 37.5 bps of yield, and according to trader conventions, OAS+48, showing real value over the bullet.Yields 1.75%. Yieldbook

OAS: +

7.2

Yieldbook

OAS: -47

Sources: Bloomberg LP, YieldBookSlide26

Major Pool: One month seasoned, $640K max loan size, $230K average loan size.

Yield at Bloomberg Consensus: 2.05%, WAL 4.92 Yield at YieldBook Speeds: 1.81%, WAL 3.92YIELDBOOK OAS: +16.4Using OAS25Convexity Story: 50 months seasoned, $85K max loan size, $65K average loan size.

Yield at Bloomberg Consensus: 1.57%, WAL 3.56Yield at YieldBook Speeds: 1.66%, WAL 3.80YIELDBOOK OAS: +39.2

Because of this frustration, I rarely use OAS in a longitudinal fashion or for cross-product comparison – even though that’s what it’s trying to do.

Rather, consider two different 15-year 3.0% MBS pools:

Finding Value in Spread Product – GIOA - March 23, 2016

Sources: Bloomberg LP, YieldBookSlide27

Liquidity RiskSection 5

26Finding Value in Spread Product – GIOA – March 23, 2016Slide28

Liquidity Risk CompensationHow much yield do I get for a bond being more difficult to convert to cash? Does my trade change the price?

27Finding Value in Spread Product – GIOA - March 23, 2016On-the-Run vs. Off-the-RunTrading VolumeIssue Size

Coupon/Dollar PriceDurationCredit RiskOption RiskSlide29

Duration Matters

28Source: Bloomberg LPTotal Bid/Ask Spread on $10 Million in T-Bills: $40

Total Bid/Ask Spread on $10 Million in 30-Yrs: $1,562.50Finding Value in Spread Product – GIOA - March 23, 2016Slide30

WFC 5.625% 12/11/20171.64% YieldG+89

1.68 Modified DurationMultibillion Dollar Issue SizeSenior Holding CompanyA2/A/AA-Coupon Size/On-the-Run vs. Off-the-Run29WFC 1.5% 1/16/20181.54% YieldG+77

1.83 Modified DurationMultibillion Dollar Issue SizeSenior Holding CompanyA2/A/AA-Finding Value in Spread Product – GIOA - March 23, 2016Difference is the coupon size and the off-the-run nature of the WFC 5.625 making it less liquid, so more spread.Slide31

Your QuestionsSection 6

30Finding Value in Spread Product – GIOA – March 23, 2016Slide32

Important Disclosures

SOURCES: Bloomberg LP; YieldBook; STRH Fixed Income Trading; Deutsche Bank; Bank of America Merrill LynchSunTrust Robinson Humphrey is the trade name for the corporate and investment banking services of SunTrust Banks, Inc. and its subsidiaries, including SunTrust Robinson Humphrey, Inc., member, FINRA and SIPC.

Debt and equity underwriting, trading, research and sales, loan syndications, municipal securities trading and sales, and mergers and acquisitions advisory services are offered by SunTrust Robinson Humphrey, Inc.Cash management, loans and loan related products, foreign exchange, risk management products and services and agency services are offered by various non-broker dealer subsidiaries of SunTrust Banks, Inc. © 2016 SunTrust Banks, Inc. SunTrust and SunTrust Robinson Humphrey are federally registered trademarks of SunTrust Banks, Inc. SunTrust Robinson Humphrey® is the trade name for the corporate and investing banking services of SunTrust Banks, Inc. and its subsidiaries. Securities and strategic advisory services are provided by SunTrust Robinson Humphrey, Inc., member FINRA and SIPC.31Finding Value in Spread Product – GIOA - March 23, 2016